Caught In a Trap

Is the so-called "liquidity trap" concept a myth?

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Federal Reserve Chairman Ben S. Bernanke may be running out of room to pump money into the financial markets and cut interest rates to rescue the economy. The Fed has committed as much as 60 percent of the $709 billion in Treasury securities on its balance sheet to providing liquidity and opened the door to more with yesterday's decision to become a lender of last resort for the biggest Wall Street dealers.

"They're using up their ammunition on the liquidity and overnight interest-rate fronts," said Lou Crandall, chief economist at Jersey City, New Jersey-based Wrightson ICAP LLC, a unit of ICAP Plc, the world's largest broker for banks and other financial institutions.

In the most dire of circumstance, the Fed could go so far as to cut its benchmark rate to zero, promise to hold it there and flood the financial system with more than enough money to ensure that happened, under a strategy known as "quantitative easing."

This sounds suspiciously like the liquidity trap scenario. The "trap" develops when the central bank simply cannot force additional credit down the throats of prospective borrowers.

Here's one way to think about the liquidity trap - a situation in which conventional monetary policy loses all traction. When short-term interest rates are close to zero, open-market operations in which the central bank prints money and buys government debt don't do anything, because you're just swapping one more or less zero-interest rate asset for another.

Right now we're in a situation in which Treasury bills yield considerably less than the Fed funds rate; to at least some extent this may reflect banks' nervousness about lending to each other, even in the overnight market. And to the extent that's true, Treasuries - not Fed funds - are the interest rates to look at.

As of 10:38 this morning, the one-month Treasury rate was 0.57; the three-month rate was 0.825. Are we there yet? Pretty close.

Milton Friedman On Liquidity Traps

Indeed the current setup is essentially the liquidity trap that Japan fell into. Wikipedia has this (and much more) to say about Liquidity Traps.

In monetary economics, a liquidity trap occurs when the economy is stagnant, the nominal interest rate is close or equal to zero, and the monetary authority is unable to stimulate the economy with traditional monetary policy tools. In this kind of situation, people do not expect high returns on physical or financial investments, so they keep assets in short-term cash bank accounts or hoards rather than making long-term investments. This makes the recession even more severe, and can contribute to deflation.

Milton Friedman suggested that a monetary authority can escape a liquidity trap by bypassing financial intermediaries to give money directly to consumers or businesses. This is referred to as a money gift or as helicopter money (this latter phrase is meant to call forth the image of a central banker hovering in a helicopter, dropping suitcases full of money to individuals).

American economist Paul Krugman suggests that what was needed was a central bank commitment to steady positive monetary growth, which would encourage inflationary expectations and lower expected real interest rates, which would stimulate spending.

Friedman Is Wrong

Milton Friedman is wrong and Japan proved it. Japan's national debt went from nowhere to 150% of GDP and they are still battling the aftermath of deflation for 18 years or more.

Artificially stimulating the economy eventually causes all sorts of problems.

The idea of a "liquidity trap" flows from a Keynesian approach to economic/monetary policy in the belief that there is not enough money in the system and things would somehow be better if more money could be forced into the system.

There are major problems with this thinking.

Throwing money at the problem simply encourages more overcapacity, weakens the currency, and causes prices of necessities like oil to rise while not doing a thing for wages. If dropping money out of helicopters worked, Zimbabwe would be the greatest economic force on the planet.

Furthermore, the Fed simply does not know the correct amount of money or the correct interest rate on it either any more than it knows how to set the correct price of orange juice or TVs. If the Fed did know, the trap would never have happened in the first place.

Who Is to Blame?

It should be clear from the above that the Fed must take a big share of the blame for the mess we are in. Ironically, the best case against the Fed was made in a speech by Fed Governor Richard W. Fisher.

A good central banker knows how costly imperfect data can be for the economy. This is especially true of inflation data. In late 2002 and early 2003, for example, core PCE measurements were indicating inflation rates that were crossing below the 1 percent "lower boundary." At the time, the economy was expanding in fits and starts. Given the incidence of negative shocks during the prior two years, the Fed was worried about the economy's ability to withstand another one. Determined to get growth going in this potentially deflationary environment, the FOMC adopted an easy policy and promised to keep rates low. A couple of years later, however, after the inflation numbers had undergone a few revisions, we learned that inflation had actually been a half point higher than first thought.

In retrospect, the real fed funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer that it should have been. In this case, poor data led to a policy action that amplified speculative activity in the housing and other markets. Today, as anybody not from the former planet of Pluto knows, the housing market is undergoing a substantial correction and inflicting real costs to millions of homeowners across the country. It is complicating the task of achieving our monetary objective of creating the conditions for sustainable non-inflationary growth.

Fed Perpetually Chasing Its Own Tail

If anyone ever wondered how or why the Fed kept blowing bigger bubble after bigger bubble the confession by Fisher above should explain it all. The Fed was too slow to halt the massive expansion of credit leading up to the dotcom bust, then overreacted on the way down which fueled the biggest housing bubble and credit lending bubbles the world has ever seen.

Clearly the Fed has no real idea where interest rates should be and thus has no business setting them.

The Austrian Approach

In the ideal Austrian approach, a self-regulating free market economy would continually set interest rates and money supply at the correct levels. The more goods and quality improvements the economy would produce, the higher the money's purchasing power would become over time.

What To Do About The Liquidity Trap

Here's what to do about the liquidity trap: Nothing. The concept of liquidity traps is imaginary. Home prices are too high, they need to correct. There are too many houses and stores so we should not encourage more building. Savings should be encouraged, not discouraged. Overcapacity needs to be worked off not fueled. Bankruptcies are part of the solution not part of the problem.

The real trap is doing something as opposed to nothing. Quantitative Easing and ZIRP did not help Japan and they will not help the US either.

The central bank simply cannot force additional credit down the throats of prospective borrowers, nor should it try. Attempts to do so will only prolong the agony while punishing innocent savers, especially those on fixed incomes.

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